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Chapter 14: Question 3Q (page 752)

Distinguish between the following interest rates for bonds payable:

(a)Yield rate

(b) Nominal Rate

(c) Stated rate

(d) Market rate

(e) Effective rate

Short Answer

Expert verified

The yield rate is the rate actually earned by the bondholders. The nominal rate is the rate fixed by the one who issues the bonds, usually expressed as a percentage on par value. The stated rate is the specified rate listed on the bond. The market rate is the current rate prevailing in the market depending on various factors. The effective rateis the true rate on the bond, which takes into account the effects of compounding.

Step by step solution

01

Meaning of Bonds Payable

Bonds payable is a liability that arises when a company issues bonds to generate cash. The company is a borrower, thus creating a liability. Bonds can be issued at par, discount, and at a premium. The pricing depends on the difference between its coupon rate and its market yield.

02

(a) Yield rate

  • Yield rate is the rate of return the bond generates. It can say what percent was made from an investment.
  • A company can use this rate to compare various projects or investments to decide which is most profitable.
  • Current Yield = Annual cash/ Bond price
03

(b) Nominal rate

  • Nominal rate is the rate bond issuer promises to pay the bond purchaser.
  • The rate is fixed, expressed as a percentage on par value, and is applied to the lifetime of the bond.
  • It is the actual interest rate stated without considering the effect of compounding.
  • Nominal rate = Annual Interest payment/ Face value
04

(c) Stated rate

  • Stated rate is the actual rate listed on the bond
  • It is the actual amount of interest paid by the bond issuer, similar to the nominal rate.
  • Example, if an issuer pays $60 on a bond with the face value of $1000, then the stated interest rate is 6%.
  • Stated rate = Bond payment/ Face value
05

(d) Market rate

  • Market rate is the prevailing rate offered on cash deposits.
  • It is determined by the current rate compared to the rate specified in the bond.
  • It considers two things: The present value of the bond`s face value & Present value of the bond`s interest payments.
  • This rate is driven by many factors such as the size and duration of deposits, the flow of funds in & out of the country, etc.
  • Market rate = Bond`s face value * Bond`s price quote
06

(e) Effective rate

  • Effective rate is the rate that will discount both the bond`s future. interest payments and the bond`s maturity value to a present value that is equal to the bond`s current market value.
  • It is similar to market and yield rate, but it takes into account the effects of compounding.
  • The more frequent the compounding period, the higher the rate.
  • Effective rate = [ 1 + i/n ] n - 1

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Most popular questions from this chapter

On January 1, 2017, Ellen Carter Company makes the two following acquisitions.

  1. Purchases land having a fair value of \(200,000 by issuing a 5-year, zero-interest-bearing promissory note in the face amount of \)337,012.
  2. Purchases equipment by issuing a 6%, 8-year promissory note having a maturity value of $250,000 (interest payable annually).

The company has to pay 11% interest for funds from its bank

Instructions

(Round answers to the nearest cent.)

  1. Record the two journal entries that should be recorded by Ellen Carter Company for the two purchases on January 1, 2017.
  2. Record the interest at the end of the first year on both notes using the effective-interest method.

Pierre Company has a 12% note payable with a carrying value of \(20,000. Pierre applies the fair value option to this note. Given an increase in market interest rates, the fair value of the note is \)22,600. Prepare the entry to record the fair value option for this note, assuming

(a) no change in credit risk, and

(b) the change is due to a change in credit risk.

Lady Gaga Co. recently made an investment in the bonds issued by Chili Peppers Inc. Lady Gaga鈥檚 business model for this investment is to profit from trading in response to changes in market interest rates. How should this investment be classified by Lady Gaga? Explain.

(Entries for Zero-Interest-Bearing Note) On December 31, 2017, Faital Company acquired a computer from Plato Corporation by issuing a \(600,000 zero-interest-bearing note, payable in full on December 31, 2021. Faital Company鈥檚 credit rating permits it to borrow funds from its several lines of credit at 10%. The computer is expected to have a 5-year life and a \)70,000 salvage value.

Instructions

(Round answers to the nearest cent.)

(a) Prepare the journal entry for purchase on December 31, 2017.

(b) Prepare any necessary adjusting entries relative to depreciation (use straight-line) and amortization (use effective interest method) on December 31, 2018.

(c) Prepare any necessary adjusting entries relative to depreciation and amortization on December 31, 2019.

(Entries for Zero-Interest-Bearing Note; Payable in Installments) Sabonis Cosmetics Co. purchased machinery on December 31, 2016, paying \(50,000 down and agreeing to pay the balance in four equal installments of \)40,000 payable each December 31. An assumed interest of 8% is implicit in the purchase price.

Instructions Prepare the journal entries that would be recorded for the purchase and for the payments and interest on the following dates.

(Round answers to the nearest cent.)

(a) December 31, 2016. (d) December 31, 2019.

(b) December 31, 2017. (e) December 31, 2020.

(c) December 31, 2018.
See all solutions

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